SEC to lift ban on actively managed ETFs relying on derivatives

Restrictions remain on leveraged and inverse strategies

The U.S. Securities and Exchange Commission is lifting its ban on actively managed exchange- traded funds that make significant use of derivatives, a move that may clear the path for more of the funds and allow changes at existing products.

The agency still won’t approve new ETFs that use derivatives to amplify returns or provide the inverse performance of an index, Norm Champ, director of the division of investment management, said today in a speech at a New York conference for investment advisers. Proposed funds will have to meet requirements on managing risk and disclosure, Champ said.

“It is a step forward for providers to be able to apply for the right to use derivatives in ETFs that do not track an index in ways commonly used by open-ended mutual funds that follow similar strategies,” said Christine Hudacko, a spokeswoman for BlackRock Inc., the largest ETF provider.

The SEC froze approval for new ETFs that make significant use of derivatives in March 2010, seven months after warning that some products could confuse individual investors. Companies with pending requests to introduce actively managed ETFs include New York-based BlackRock Inc. and Atlanta-based Invesco Ltd.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather. Champ said the SEC will continue to review the use of derivatives by funds.

“Given the complexity and significance of the issues relating to funds’ use of derivatives, both for the fund industry and for the protection of investors, we are taking a deliberate approach in our continuing review,” he said.

Pimco ETF

Bill Gross, manager of the Pimco Total Return Fund, the world’s biggest bond mutual fund, may be able to more closely mimic that product with the actively run ETF designed to match its investment strategy. The mutual fund uses a combination of options, futures and swap agreements, tools that have been prohibited for the ETF.

Gross’s Pacific Investment Management Co., based in Newport Beach, California, said in a filing last year it would use derivatives in the ETF if the SEC should lift the ban. Even with those restrictions, the ETF has grown to $3.8 billion since its introduction in February, making it one of the 15 biggest bond ETFs in the U.S.

Pimco Total Return ETF has returned 12 percent since inception, compared with 7.4 percent for Gross’s mutual fund.

Active ETFs seek to combine the skill of a manager selecting investments with the trading flexibility, lower fees and tax advantages of ETFs, which typically track an index. ETFs hold baskets of securities, commodities or other assets while trading throughout the day like individual stocks.

Almost all ETFs track indexes tied to benchmarks, appealing to investors because of their trading flexibility and lower costs. Actively managed ETFs in the U.S. oversee about $10.3 billion, or about 0.8 percent of the industry total, according to data compiled by Bloomberg and Morningstar Inc.